The Failures of Mark-to-Market Accounting, Part 2

MtM has been a means for miscommunication.

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Editor's Note: This is Part 2 of a two-part article. Part 1 can be found here.

Marking MtM to Market

Proponents of Mart-to-Market (MtM) argue that basing values on current prices provides an accurate picture of a firm's financial position. In particular, it's superior to the alternative -- historical cost accounting -- where assets and liabilities are valued at the price at the time the transaction was entered into.

MtM accounting may, in fact, distort the price of assets. Under historical accounting, if the market value of a bank's loans increase above historical cost, then there's an incentive for management (who are judged on current profits) to sell the loans. This allows the profit to be realized irrespective of whether the market values the asset accurately. The sale is in the interest of the managers but not necessarily of the shareholders, who may be better off if the loans weren't sold (especially if the market value is below the "true" economic value of the asset). Under MtM accounting, in theory, the loans don't have to be sold as marking the assets to market value enables the gain to be realized.

In a falling market, this process works perversely resulting in the uneconomic sale of long-term, illiquid assets. If observed market prices are low (below perceived value) due to lack of liquidity, then firms may try to sell assets in an attempt to establish higher observed prices. If all firms behave in this way, the resultant selling may drive prices down. This penalizes shareholders that would have benefited from the assets being held,as in the absence of default, they'd receive face value rather than the (lower) market price.

The research highlights that MtM accounting is pro-cyclical and creates volatility of asset values through complex positive and negative feedback loops. Under normal market conditions where asset markets are liquid, MtM accounting works benignly. In volatile markets, where behavior becomes linked by a common factor -- such as disclosure required by MtM accounting -- coordinated actions of market participants can easily lead to sharp movements in asset prices. The process distorts market prices and ultimately the firm's financial position and value.

In the current crisis, MtM accounting has exacerbated uncertainty. Banks have constantly misjudged values of assets. This uncertainty has been destabilizing to market confidence.

The new accounting framework has actually been an impediment to dealing with the problem. In a pre-MtM environment, banks may have responded to the deterioration in asset quality by writing exposures to conservative values to remove uncertainty. This would then have allowed them to re-capitalize to an adequate level to restore confidence. In a MtM environment, there's less flexibility. Firms have been forced to mark assets to unreliable market prices, causing them to progressively follow the market down. This has resulted in a "drip feed" of losses and a succession of capital-raising measures that have increased uncertainty.

Robert Kaplan, Robert Merton, and Scott Richard writing in the Financial Times on August 17, 2009) asserted that: "Financial assets, even complex pools of assets, trade continuously in markets." This would have been news to those in the real world that struggle daily to get meaningful prices for many securities and assets.

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